Instruments of the Money Market

INSTRUMENTS OF THE MONEY MARKET

The followng chapters were originally published in the seventh

edition of Instruments of the Money Market, edited by Timothy

Q. Cook and Robert K. Laroche. The information in this

publication, although last revised in 1993 and no longer in

print, is still frequently requested by academics, business

leaders, and market analysts. Given the book's popularity, the

Federal Reserve Bank of Richmond has made it available on

the Internet.

Each chapter is available seperately below. For printing

purposes a PDF file of the entire publication has been made

available.

Foreward

Chapter 1

The Money Market

1

Chapter 2

Federal Funds

7

Chapter 3

The Discount Window

22

Chapter 4

Large Negotiable Certificates of Deposit

34

Chapter 5

Eurodollars

48

Chapter 6

Repurchase and Reverse Repurchase Agreements

59

Chapter 7

Treasury Bills

75

Chapter 8

Short-Term Municipal Securities

89

Chapter 9

Commercial Paper

105

Chapter 10 Bankers Acceptances

128

Chapter 11 Government-Sponsored Enterprises

139

Chapter 12 Money Market Mutual Funds and

156

Other Short-Term Investment Pools

Chapter 13 Behind the Money Market: Clearing and

173

Settling Money Market Instruments

Chapter 14 Money Market Futures

188

Chapter 15 Options on Money Market Futures

218

Chapter 16 Over-the-Counter Interest Rate Derivatives

238

Index

FOREWORD

This edition of Instruments of the Money Market contains two chapters on subjects that were not included in

the sixth edition: over-the-counter interest rate derivatives and clearing and settling in the money market. All

of the other chapters have been either completely rewritten or thoroughly revised to reflect developments in

recent years.

All but three of the authors of the chapters in this edition were at the Federal Reserve Bank of

Richmond when they wrote their chapters. Stephen A. Lumpkin is an economist at the Board of Governors

of the Federal Reserve System. Jeremy G. Duffield is with The Vanguard Group of Investment Companies.

Thomas K. Hahn is a financial consultant with TKH Associates.

Numerous market participants and Federal Reserve staff members generously provided information that

was helpful in writing this edition of Instruments of the Money Market. These include Lawrence Aiken,

Federal Reserve Bank of New York; Keith Amburgey, International Swap Dealers Association; Albert C.

Bashawaty, Morgan Guaranty Trust Co.; Jackson L. Blanton, Federal Reserve Bank of Richmond; Richard

S. Cohen, Chase Manhattan Bank, N. A.; Jerome Fons, Moody's Investors Service; David Humphrey,

Florida State University; Ira G. Kawaller, Chicago Mercantile Exchange; Thomas A. Lawler, Federal National

Mortgage Association; Patrick M. Parkinson, Board of Governors of the Federal Reserve System; Steen

Parsholt, Citibank, N. A.; Mitchell A. Post, Board of Governors of the Federal Reserve System; David E.

Schwartz, Mitsubishi Capital Market Services, Inc.; Robert J. Schwartz, Mitsubishi Capital Market Services,

Inc.; David P. Simon, Board of Governors of the Federal Reserve System; James W. Slentz, Chicago

Mercantile Exchange; Robert M. Spielman, Chase Manhattan Bank, N. A.; Bruce Summers, Federal

Reserve Bank of Richmond; Walker Todd, Federal Reserve Bank of Cleveland; and Alex Wolman,

University of Virginia.

We are especially grateful to staff members at the Federal Reserve Bank of Richmond who did such an

excellent job in producing the book. Elaine Mandaleris, the Research Department's publications supervisor,

provided critical support in the initial stages of the book's production and in the coordination of the staff.

Dawn Spinozza, the managing editor for Instruments, did an exceptional job in editing the copy and

organizing the ongoing production of the book. Gale (Geep) Schurman, the graphic artist, did an excellent

job in producing the charts and design work. Lowell Brummett, the compositor, provided expert skill and

judgment in putting together the final output.

Page 1

The information in this chapter was last updated in 1993. Since the money market evolves very rapidly, recent

developments may have superseded some of the content of this chapter.

Federal Reserve Bank of Richmond

Richmond, Virginia

1998

Chapter 1

THE MONEY MARKET

Timothy Q. Cook and Robert K. LaRoche

The major purpose of financial markets is to transfer funds from lenders to borrowers. Financial market

participants commonly distinguish between the "capital market" and the "money market," with the latter term

generally referring to borrowing and lending for periods of a year or less. The United States money market is

very efficient in that it enables large sums of money to be transferred quickly and at a low cost from one

economic unit (business, government, bank, etc.) to another for relatively short periods of time.

The need for a money market arises because receipts of economic units do not coincide with their

expenditures. These units can hold money balances¡ªthat is, transactions balances in the form of currency,

demand deposits, or NOW accounts¡ªto insure that planned expenditures can be maintained independently

of cash receipts. Holding these balances, however, involves a cost in the form of foregone interest. To

minimize this cost, economic units usually seek to hold the minimum money balances required for day-today transactions. They supplement these balances with holdings of money market instruments that can be

converted to cash quickly and at a relatively low cost and that have low price risk due to their short

maturities. Economic units can also meet their short-term cash demands by maintaining access to the

money market and raising funds there when required.

Money market instruments are generally characterized by a high degree of safety of principal and are

most commonly issued in units of $1 million or more. Maturities range from one day to one year; the most

common are three months or less. Active secondary markets for most of the instruments allow them to be

sold prior to maturity. Unlike organized securities or commodities exchanges, the money market has no

specific location. It is centered in New York, but since it is primarily a telephone market it is easily accessible

from all parts of the nation as well as from foreign financial centers.

The money market encompasses a group of short-term credit market instruments, futures market

instruments, and the Federal Reserve's discount window. The table summarizes the instruments of the

money market and serves as a guide to the chapters in this book. The major participants in the money

market are commercial banks, governments, corporations, government-sponsored enterprises, money

market mutual funds, futures market exchanges, brokers and dealers, and the Federal Reserve.

Page 2

Commercial Banks

Banks play three important roles in the money market. First, they borrow in the

money market to fund their loan portfolios and to acquire funds to satisfy noninterest-bearing reserve

requirements at Federal Reserve Banks. Banks are the major participants in the market for federal funds,

which are very short-term¡ªchiefly overnight¡ªloans of immediately available money; that is, funds that can

be transferred between banks within a single business day. The funds market efficiently distributes reserves

throughout the banking system. The borrowing and lending of reserves takes place at a competitively

determined interest rate known as the federal funds rate.

Banks and other depository institutions can also borrow on a short-term basis at the Federal Reserve

discount window and pay a rate of interest set by the Federal Reserve called the discount rate. A bank's

decision to borrow at the discount window depends on the relation of the discount rate to the federal funds

rate, as well as on the administrative arrangements surrounding the use of the window.

Banks also borrow funds in the money market for longer periods by issuing large negotiable certificates

of deposit (CDs) and by acquiring funds in the Eurodollar market. A large denomination CD is a certificate

issued by a bank as evidence that a certain amount of money has been deposited for a period of time¡ª

usually ranging from one to six months¡ªand will be redeemed with interest at maturity. Eurodollars are

dollar-denominated deposit liabilities of banks located outside the United States (or of International Banking

Facilities in the United States). They can be either large CDs or nonnegotiable time deposits. U.S. banks

raise funds in the Eurodollar market through their overseas branches and subsidiaries.

A final way banks raise funds in the money market is through repurchase agreements (RPs). An RP is a

sale of securities with a simultaneous agreement by the seller to repurchase them at a later date. (For the

lender¡ªthat is, the buyer of the securities in such a transaction¡ªthe agreement is often called a reverse

RP.) In effect this agreement (when properly executed) is a short-term collateralized loan. Most RPs involve

U.S. government securities or securities issued by government-sponsored enterprises. Banks are active

participants on the borrowing side of the RP market.

A second important role of banks in the money market is as dealers in the market for over-the-counter

interest rate derivatives, which has grown rapidly in recent years. Over-the-counter interest rate derivatives

set terms for the exchange of cash payments based on subsequent changes in market interest rates. For

example, in an interest rate swap, the parties to the agreement exchange cash payments to one another

based on movements in specified market interest rates. Banks frequently act as middleman in swap

transactions by serving as a counterparty to both sides of the transaction.

Page 3

The Money Market

Principal

Borrowers

Instrument

Federal Funds

Banks

Discount Window

Banks

Negotiable Certificates of

Deposit (CDs)

Banks

Eurodollar Time Deposits

and CDs

Banks

Repurchase Agreements

Securities dealers, banks,

nonfinancial corporations,

governments (principal

participants)

Treasury Bills

U.S. government

Municipal Notes

State and local governments

Commercial Paper

Nonfinancial and financial

businesses

Bankers Acceptances

Nonfinancial and financial

businesses

Government-Sponsored

Enterprise Securities

Farm Credit System,

Federal Home Loan Bank

System, Federal National

Mortgage Association

Shares in Money Market

Instruments

Money market funds, local

government investment

pools, short-term

investment funds

Futures Contracts

Dealers, banks (principal users)

Futures Options

Dealers, banks (principal users)

Swaps

Banks (principal dealers)

A third role of banks in the money market is to provide, in exchange for fees, commitments that help

insure that investors in money market securities will be paid on a timely basis. One type of commitment is a

backup line of credit to issuers of money market securities, which is typically dependent on the financial

condition of the issuer and can be withdrawn if that condition deteriorates. Another type of commitment is a

credit enhancement¡ªgenerally in the form of a letter of credit¡ªthat guarantees that the bank will redeem a

security upon maturity if the issuer does not. Backup lines of credit and letters of credit are widely used by

commercial paper issuers and by issuers of municipal securities.

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